Are CDs Good Protection For The Bear Market?

A bear market is usually an indication of a sluggish economy and a decrease in the value of overall securities. During this time, consumers tend to be pessimistic in their outlook about financial assets and the economy as a whole. In a bear market, investors always tend to look into where their investments can be better protected, or which investment vehicles to add to their portfolios to help lessen the blow to their stocks and equity investments. Products investors commonly look into during these difficult times are more stable, income-producing debt instruments such as certificates of deposit (CD). But are CDs actually good protection for a bear market? Read on to find out.

What Is a CD?A certificate of deposit is a short- to medium-term deposit in a financial institution at a specific fixed interest rate. You are guaranteed the principal plus a fixed amount of interest at maturity, which is the end of the term. The period of the term varies, but generally you can purchase three-month, six-month, nine-month, or one- to five-year CDs. Some banks have even longer-term CDs.

CDs are considered time deposits because the purchaser agrees at the time of purchase to leave his or her deposit in the bank for the specific period of time. Make sure you can afford to let go of some of your money for a certain period of time before committing to a CD, because if the purchaser decides to take back the deposit before maturity, he or she will be liable for a penalty, which varies from as little as a week's worth of interest to a month or six months' interest. Any fees or penalty amounts are required to be disclosed upon opening the CD account. (Build Yourself An Emergency Fund can help you ensure you won't have to liquidate your CD in a pinch.)

One major drawback to withdrawing before the term is due is that the penalty imposed could decrease not only the interest, but also the principal amount. This can happen if you purchase a 13-month CD and decide to cash it at three months. The penalty on this CD would be to pay off six months' worth of interest. Unfortunately, your CD has not even earned that amount of interest yet – and so the penalty digs into your principal amount.

Although CDs are considered low-return investments, the return is guaranteed at the specific interest rate even if market rates go lower. Typical CDs are not protected against inflation, so when shopping for a CD, try to buy one higher than the inflation rate so that you can get the most value for your money. The longer the term of the CD, the higher the interest rate will be. Although rates on CDs are not the highest in the debt instrument market, CDs earn more in interest than most money market accounts and savings accounts. (Learn more about these two deposit options in Money Market Vs. Savings Accounts.)

CDs Vs. StocksStocks tend to have a higher rate of return than most securities, but this is because of the higher risk that is involved. If a company goes through rough times, the stockholders will be the first to feel it. If the stock loses value as a result of bad management or a lack of public interest in its products or services, the value of your portfolio may be compromised. However, if the company does really well, the return you can obtain from its stock's value could be significantly higher than you would've obtained through a CD investment. (Learn more in Why Stocks Outperform Bonds.)

For the past several years, the stock market has been through turbulent ups and downs, resulting in great losses for some stockholders. CDs are one option that can help protect your investment from these times of turmoil by providing a stable income. Although the returns gained from these investments won't usually be as high as those provided by stocks, they can serve as a "cushion" to balance your portfolio and keep it afloat when the market is down in the dumps. Because CD rates are locked in for a certain period of time, the interest rate agreed upon at the time of purchase is the interest rate that will be gained on the CD despite how poorly the market might be doing. In addition, unlike stocks and various other investment vehicles, CDs are almost always insured. (Learn how to protect your portfolio through diversification in Introduction To Diversification and Diversification: It's All About (Asset) Class.)

Guaranteed ProtectionCDs are primarily a safe investment. They are guaranteed by the bank to return the principal and interest earned at maturity. The Federal Deposit Insurance Corporation (FDIC) insures certificates of deposit for up to $250,000 for each depositor at each insured bank. This means that it will guarantee payment of your CD investment if the bank goes under. The National Credit Union Administration (NCUA) serves the same purpose for its insured credit unions.

Knowing how much insurance you have against bank failure is essential, especially when the stock market is not faring well. It is during these times that investors tend to look deeper into insured investments. Neither the FDIC nor the NCUA insures stocks, bonds, mutual funds, life insurance, annuities or municipal securities. (For more on making sure your money is safe, read Are Your Bank Deposits Insured? and Bank Failure: Will Your Assets Be Protected?)

When searching for CD products, it is a good idea to look into how well the bank offering the CDs is doing. The FDIC has a watch list where it lists banks that might be in trouble; however, according to the FDIC, they never release ratings on the safety of financial institutions to the public. To get an idea of the how banks are performing, consumers need to visit the listings of several financial institution rating services provided on the FDIC's website. For further info visit FDIC.gov, and review detailed credit union data at NCUA.gov.

In addition to commercial banks, thrifts and credit unions, you can also buy CDs through brokerage firms or online accounts. One drawback to buying through a brokerage account is that the broker is considered a third party to the transaction - it is buying the CD from a bank and selling it to you. If a bank fails, it will take longer to get your money back because the request will have to go through the brokerage rather than directly to the bank. (Read more about the role of a broker in Full-Service Brokerage Or DIY?)

CD LadderingCD laddering can provide a flexible security blanket if done properly. Laddering helps lower your risk while increasing your return, because it allows you to continue investing in the highest-rated CDs available. The method is to use your funds to buy CDs at different maturities and interest rates. Here's how it works:

When you start a CD ladder, research the best rates, either locally or in different states. Let's say you have $5,000 in your minimal interest-bearing savings account. Because you want to make the most of your stationary money, you decide that a CD with an interest rate of 3% looks much more appealing. Do not use money you'll need for emergencies. After you decide this is money you can afford to lock up for a period of time, go ahead and start your ladder. You can begin by buying five different CDs at various rates and maturity dates. For example, the ladder could consist of purchasing the following CDs, each at $1,000:

a one-year CD at 3% interest

a two-year CD at 3.5% interest

a three-year CD at 3.7% interest

a four-year CD at 3.9% interest

a five-year CD at 4.1% interest

When the first CD matures, you will have the flexibility of either reinvesting by rolling it into a higher CD rate or cashing it out. In laddering, you will roll it over. When your CD matures, roll it over into a higher-rated five-year CD. When your second-year CD matures, roll it over into another five-year high-rated CD, and continue doing the same until you've rolled over all your initial CDs. Because a CD in your ladder will mature each year, you will always have liquid money available. The advantage of laddering like this is that you will always get the benefit of the highest interest by rolling into the longer-term five-year CD. (For more details, read Step Up Your Income With A CD Ladder.)

Tax ConsequencesInterest that you earn on your CD throughout its term is taxable. The tax on it depends on your tax bracket. According to the Internal Revenue Service (IRS), you must report the total interest you earn on the certificate of deposit every year. Even if the interest on the CD was not paid to you directly, you will be taxed on the amount earned in that year. Interest income is considered ordinary income and taxed as such.

ConclusionCDs are a comparatively safe investment. If they are managed properly, they can provide a stable income regardless of stock-market conditions. When considering the purchase of CDs or starting a CD ladder, always consider the emergency money you might need in the future. Laddering can help protect your investments by providing you with stable interest income in a bear market (or any market, for that matter), but make sure you can afford to do without that money for the term of the CD, and investigate the institution you decide to buy from.